Written by: Jason Lawit | Senior Managing Director at Northern Trust
With markets again at or near all-time highs there has been a refreshed round of calls for caution and timing. Market timing is an attempt to sell one security and buy another and benefit in the trade. The common example is selling stocks and buying bonds when you think the stock market is overpriced and due for a downward price adjustment. The hope for the strategy is you will get out of the stock market, avoid a downward price movement and then re-enter the market at a more attractive price point.
Let’s take a step back and consider the components of market timing. If prices of public securities (both stocks and bonds) are fair ( i.e ., all available information is incorporated into price), how can you time the market? You would be merely trading one properly priced instrument for another. Because the price of a public security (both stocks and bonds) reflects all current information, by definition – only new information will change the current price. New information is unknowable. Accordingly, market timing is an illusion and, perhaps (as discussed later), a harmful illusion.
The suggestion public market prices are fair is supported in a number of ways:
1. The sheer volume of daily trading which supports the equilibrium price.
2. The weight of academic research which does not find the existence of mutual fund managers who add value above risk adjusted return ( See , Fama and French, “ Luck vs. Skill in the Cross Section of Mutual Fund Returns ,” Journal of Finance (2010)).
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3. Review of live performance of active managers.
So what really happens when you attempt to market time (sell stocks and buy bonds)?
You reduce risk and expected return in your portfolio. You do so in a ratio that is fair and currently reflected in market prices. If you do not need the higher returns of equities through time to help fund your goals, you might be fine. You just exhibited a risk preference related to your fear of the unknowable. If, however, you do need to capture equity returns through time to have an expectation of being able to fund goals far off in the future – your fear of the unknown may have just diminished your chances of successfully funding your goals. And, don’t forget, future market timing cannot be relied upon as a mechanism to have your portfolio catch up to where it needs to be to fund goals.
So, if you are relying upon your (or someone else's) ability to market time to help you fund your goals, you are likely to fall short. Not because prices aren’t fair, but because market timing does not exist and your behavioral biases will be quietly working against you.